Download REIT Valuation - Real Estate Society

REIT Valuation and
Investment
Session Objectives
Basic stock market valuation model
 Are REITs “Growth” or “Income” stocks?
 REIT Conflicts of Interest
 REIT Management Issues
 Two Competing Valuation Models
 Investor Considerations
 REIT NAV Analysis

REIT Valuation in the Stock Market
Stock market is highly integrated.
 REIT equity shares are traded in the stock
market.
 So REITs are valued essentially like other
stocks…
DIV3
DIV1
DIV2
E



2
3
1  r (1  r )
(1  r )

Gordon Growth Model
DIV1
E
rg
(Based on forward-looking long-run
average r and g.)
 DIV1  EBTCF from current properties =
PBTCF – DS.

Gordon Growth Model

g is very important. Reflects:
 LR
growth in EBTCF (“same store growth”)
 LR ability of REIT mgt to generate “growth
opportunities” (NPV>0 projects)

r = Firm’s equity OCC
=
rf + RP = y + g , in the firm’s equity:
r  r f   E[rM ]  r f 
DIV1
r
g
E
Are REITs growth stocks or income
stocks?…

Beneficial of Boston (BOB): An “income
REIT”…
 Owns
properties that pay $100 million / yr, in
perpetuity, no debt.
 OCC = r = 10%;
g = 0.
 Using GGM, BOB’s equity is worth:
E BOB
$100 million $100 million


 $1000 million
0.10  0.0
0.10

Sioux Realty (Sioux): A “growth REIT”…
 Sioux
owns stabilized operating properties like BOB’s
that pay $50 million / yr in perpetuity, no debt, plus:


Land on which a completed project worth $3,000 million in
one year can be built, at a cost of $600 million construction.
Due to the risk in this development project (note the
operational leverage), the OCC for this project is 20%.
 Thus,
Sioux’s value is:
E SIOUX  PV ( Existing )  PV (Growth)
$50 million $600 million


0.10  0.0
1  0.20
 ($500  $500) million
 $1000 million
BOB’s and Sioux’s Price/Earnings
multiples are:
P / EarnBOB
$1000 million

 10
$100 million
P / EarnSIOUX
$1000 million

 20
$50 million
Concept Check


If they pay out all their income as dividends,
what are the current yields of these two REITs?
Why is Sioux a “growth REIT”?…
 Is

it because they “do development projects”?…
Suppose they did not already own the land (and
were similar to the “second best developer” on
the site)?


Growth stocks have positive NPV opportunities.
Typical sources in REITs (if any):

Land already owned.
 Entrepreneurial abilities (in development, or possibly other activities).
 Macro-level abilities (scale economies?, franchise value?, econ of
scope?)
 Differential property asset valuation in stock vs private property markets.

“Most REITs are not growth stocks most of the time, but some
REITs are growth stocks most of the time, and most REITs are
growth stocks some of the time.”
Agency Issues: Conflicts of Interest

Some major issues to watch out for…

1) Transaction bias in UPREITs:


2) Real estate interests outside the REIT:


Due to tax-based conflict (different cost basis for LP investors vs
public stock investors)?…
Do REIT managers have other real estate interests that compete
with the REIT’s properties or for the managers’ time & energy (other
properties not in the REIT, other interests such as brokerage or
management firms)?…
3) Potential for “self-dealing”:

Do REIT managers have incentives to have the REIT engage in
“Sweatheart” deals with brokerage, management, development
firms in which they have interests?…
REIT Strategic Management

The traditional real estate cliché about the
“3 determinants of value”:


“Location, location, location”.
The modern REIT cliché about the “3
determinants of value”:
 “Management,
management, management”.
Six Strategic Considerations

1) Financial strategy:


REITs don’t have traditional Corp income tax-based rationale for
use of debt financing. But REITs often need external capital
(R.E. is capital-intensive, and REITs must pay out 95% of
earnings).
Various considerations enter the REIT capital structure equation,
among which…




Stock market wants growth;
Real estate is not a growth asset without lots of leverage (especially
with short-term or floating-rate debt);
Stock market doesn’t like REITs to be highly levered (especially with
short-term or floating-rate debt).
 Solution: walk the tightrope carefully.

2) Specialize (know your market):
 Be
a “residential REIT” or a “retail REIT”,
etc…
 Sometimes some combinations are “OK”
(e.g., office & industrial)
 Geographical specialization is “less cool” (you
gotta get scale economies somehow!)

3) Build “franchise value” (brand name
recognition?):
 Improve
tenant service with increased
geographical and product scope.

4) Consider “vertical integration”:
 Land,
Development, Asset ownership, Property Mgt,
Leasing, Tenant Services (logistics, communications,
etc), Information (databank);
 Allows REIT to ride through periods when stock
market undervalues real estate assets relative to the
property market (sell most asset ownership into
property market, retain control and ancillary functions,
possibly develop new buildings);
 During periods of low property market asset valuation
relative to the stock market, buy existing properties
and bank buildable land).

5) Take advantage of Economies of Scale (such
as they are):
 Are
there scale economies in REIT administrative
costs?…
 Are there scale economies in REIT capital costs?…
 Where are the limits of such economies?…
 Are there economies of scope in REIT service
provision?…

6) Try to develop some market power
(“monopoly control”) in local space
markets:
 Buy
(or build) most of the space of a given
type in a given local submarket;
 But beware, rare is the submarket that has no
potential close substitute in the same metro
area.
Two Models of REIT Valuation

1) The REIT as a closed-end mutual fund:
 It’s
just a collection of assets with an added layer of
management (hence, added risk, added potential for
agency cost);
 Value creation only as a “pass-through” vehicle for
passive investors wanting a real estate play…
  Trades at a discount below NAV (private property
market asset value).

2) The REIT as a vertically-integrated firm:
 It’s
an entrepreneurial corporation (like other industrial
and service companies in the stock market, possibly
subject to some economies of scale);
 Value creation via skillful management and
generation of unique real estate ideas and options,
providing some growth (NPV>0) opportunities…
  Trades at a premium to NAV (private property
market asset value).
How do you estimate NAV?
Some REIT Investor
Considerations

1) Choosing between public (REIT) versus private (direct
property) investment in real estate…




Direct investment in private R.E. has problems regarding
illiquidity, need for active management and specialized local
expertise, and lumpy scale (capital constraints).
But REITs provide less diversification in a stock-dominated
portfolio, and have more volatile, less-predictable returns.
 Small investors without specialized expertise should probably
stick with REITs.
 Large investors or those with specialized expertise can
benefit from direct private investment (albeit also with some
REIT investment for tactical or strategic portfolio management).

2) REIT behavior in the stock market…
 On
average REITs tend to be high-yield, low-beta
stocks (  0.5, typically a small-to-mid cap value
stock);
 REITs tend to exhibit higher beta during market
downswings than during upswings (  0.8 in downmarkets, 0.3 in up-markets – typical of value stocks);
 REITs are probably not be useful for timing the stock
market, but they may be useful as a tactical tool for
taking advantage of asset market cycles in the private
property market (which is more predictable than the
stock market).